New prudential guidance may increase capital requirement for many payments and e-money firms

Generally the regulatory capital requirement for payments and e-money firms is based on straightforward formulas related to payment volumes, e-money issuance or fixed overheads found in the PSRs or the EMRs. Although the FCA can direct such firms to hold capital up to 20% higher than they would otherwise hold subject to factors such as their risk management controls, typically, regulatory capital has not been a function of general risk factors in the business.

The effect of the FCA’s new guidance – FG 20/1 “Our framework: assessing adequate financial resources” – is to introduce, what amounts to, an effective shadow ICAAP (Internal Capital Adequacy Assessment Process) requirement to the payments sector. The ICAAP is a GENPRU requirement for a documented review that, inter alia, identifies, measures, monitors and reports key risks as well as informs risk appetite. Its conclusions determine whether a firm has sufficient capital to cover those risks now and in the future, or whether it needs to increase capital. 

This new FCA guidance will not only increase the regulatory burden on payments and e-money firms, many of which will have to embolden their risk frameworks, controls and wind-down planning, but crucially, it may also require many such firms to hold more capital against identified risk in their businesses.  

As set out in our article of 9 June 2020, the financial resilience of firms has become an increased focus for the FCA in the light of the coronavirus pandemic – a notable change in emphasis given that the FCA, as a conduct regulator, has not, to date, looked intently at issues of capital and solvency. So far, nowhere has that increased focus been more in evidence than in the payments sector. The FCA has stated that its particular concerns about payments firms stem from the fast growth of many such firms; that many are unprofitable in the early stages; and that the pandemic may affect these firms’ financial strength and the availability of their external funding.

The action it has taken so far this year in the payments sector has been striking:

• in April, the FCA identified payment services provision as a sector priority for supervision and intervention in its 2020/21 Business Plan;
• in May, the FCA proposed temporary guidance to strengthen payment firms’ prudential risk management and arrangements for safeguarding customers’ funds in light of the exceptional circumstances of the coronavirus pandemic (the “Temporary guidance“) summarised below; and 
• on 11 June, the FCA published: FG 20/1 “Our framework: assessing adequate financial resources”.

This article is concerned with the latter two developments.

FG 20/1 “Our framework: assessing adequate financial resources”

This significant new prudential guidance is applicable to most FCA solo-regulated firms including PIs and EMIs by reason of such firms becoming subject to PRIN. The effect of FCA guidance is that the FCA will not take action against a person for behaviour that it considers to be in line its guidance (DEPP 6.2.1(4).

The FCA states that the “guidance does not place specific additional requirements on firms because of Covid-19, but the crisis underlines the need for all firms to have adequate resources in place and to assess how those needs may change in the future”.  Further, the FCA states that it does not seek to “impose additional requirements on firms, rather to clarify our view of the meaning of adequate financial resources by reference to best practice, to be applied by firms on a case by case basis in a proportionate way”. However, the guidance will materially impact payments and e-money firms as well as other non-ICAAP firms (smaller and non-interconnected firms (“Class 3” firms)).

The key requirement of the guidance is to have financial resources commensurate to the risk of harm of the firm’s business. The FCA sets out what it would consider key in any review that it undertakes of a firm’s own assessments of adequate financial resources, the main points being: 

• does a firm have a risk management framework which includes a clear risk appetite? 
• does a firm appropriately and adequately identify the risks to which it is exposed and the materiality of each risk? 
• how adequate are systems and controls in place? 
• has adequate use been made of stress testing in the risk assessment? 
• does the risk assessment process meet the ‘use test’ i.e. is it used day-to-day and for decision making? 
• does the firm have adequate financial resources based on the risks to which it is exposed?

A number of themes are repeated from the Temporary guidance published for consultation in May (expanded on below) which focused particularly on payments firms including the importance of systems and controls, governance and culture; and wind-down planning (although wind-down plans are stated not to be mandatory, the FCA proposes to introduce a stricter requirement in the Temporary guidance). 

Firms are expected to identify all significant harms related to the activities they undertake. An FCA example of a potential harm caused by a payment services firm would be failing to have resilient systems and controls which result in serious harm to consumers from disruption to continuity of service, particularly if the provider has a dominant position in the market. 

The Temporary guidance: Coronavirus and safeguarding customers’ funds: proposed guidance for payment firms

The Temporary guidance from the May communication builds on the payment services approach document (Approach Document), but adds some significant new obligations in the areas of on safeguarding, managing prudential risk, and wind-down plans. Responses to the consultation closed on 12 June 2020. The FCA plans to publish a letter to CEOs of Payment Service Providers (PSPs) and will conduct a full consultation later in the year on changes to its Approach Document, which will likely include a proposal to incorporate in the Approach Document this temporary guidance. The guidance covers the following areas:

Governance and controls

PIs and EMIs should ensure they have robust governance arrangements, effective procedures, and adequate internal control mechanisms. A firm’s senior management should ensure that the firm regularly reviews its systems and controls, including its governance arrangements. It should also ensure that the firm’s governance functions, procedures and controls appropriately reflect the firm’s business model, its growth and relevant risks.

Capital adequacy

Firms must accurately calculate their capital requirements and resources on an ongoing basis, and report these correctly to the FCA in regulatory returns. A firm’s senior management should ensure that its capital resources are reviewed regularly.

To reduce exposure to intra-group risk, the FCA considers it best practice for firms to ensure that there is an adequate level of financial resources within each individual regulated entity at all times to absorb losses e.g. by deducting any assets representing intra-group receivables from their own funds.

Liquidity and capital stress testing

Firms should carry out liquidity and capital stress testing to analyse their exposure to severe business disruptions and assess their potential impact, using internal and/or external data and scenario analysis. Firms should use the results of these tests to help ensure they can continue to meet their conditions of authorisation and own funds requirements. In particular, they should use these results to inform their decisions around adequate liquidity and capital resources, as well as identifying any changes and improvements to required systems and controls.

Risk management arrangements

As part of their liquidity risk-management procedures, the FCA expects firms to consider their own liquid resources and available funding options to meet their liabilities as they fall due, and whether they need access to committed credit lines to manage their exposures. To reduce exposure to intra-group risk, it considers it best practice for firms not to include any uncommitted intra-group liquidity facilities when assessing whether they have adequate resources in place to cover the liquidity risk to which they are exposed.

Wind-down plans

The FCA “clarifies” that its conditions for authorisation which require a firm to satisfy it that they have effective procedures to manage any risks to which they might be exposed now includes the requirement that they have a wind-down plan to manage their liquidity and resolution risks. The wind-down plan should consider the winding-down of the firm’s business under different scenarios, including a solvent and insolvent scenario. In particular, the wind-down plan should include/address the following:

• appropriate funding to cover the solvent wind-down of the firm, including the costs of the wind-down and the return of all customer funds;
• realistic triggers to enter into wind-down and, possibly, insolvency;
• the need for any counterparties (i.e. merchants) to have time and support to find alternative providers; and
• information provided by the wind-down plan which would help an administrator or liquidator to quickly identify customer funds and return them as a priority.

The FCA has published general guidance for Part 4A FSMA authorised firms on Wind-down Planning  which will help firms in this work.

Although not expanded on here, the FCA also set out in its Temporary guidance some “clarifications”, and a more prescriptive approach, to safeguarding.

How can we help?

Action needed 

FG 20/1 and the Temporary guidance call for action by PIs and EMIs.  Firms should:

1. undertake a full risk assessment with reference to both sets of guidance, including in particular, the risks related to the firm’s business model and strategy;
2. consider as part of this risk assessment, a detailed review of the firm’s capital returns and the adequacy of capital and liquidity, including (where applicable) intra-group risk;
3. develop a robust risk management framework and a stress testing programme;
4. ensure that wind-down plans are drawn up and/or reviewed; and
5. review governance arrangements against best practice and ensure that the risk management framework is embedded.

Firms will need to assess with advisers the extent to which the guidance can be applied in a proportionate way given the range of type of firm in the payments sector.

We have extensive experience in the payments and e-money sector; and of identifying and mitigating risk in these businesses.